Life insurance policies are attractive vehicles providing tax-advantaged growth that the stock market doesn’t hinder. As a result, throwing as much money as possible into the account can be tempting. After all, who wouldn’t want to maximize their gains Unfortunately, contributing too much money into your account can result in the policy becoming a modified endowment contract. This account designation is unchangeable once assigned and produces different implications for taxes and cash value access. Here are the details and how to use the seven-pay test to stay on the straight and narrow. You may also want to work with a financial advisor to help you make the right long-term financial decisions.
What Is a Modified Endowment Contract (MEC)?
A modified endowment contract (MEC) is a former life insurance policy that has lost specific advantages due to accumulating surplus cash. For instance, permanent life insurance policies, such as whole life insurance, defer taxes on growth.
In addition, the policy’s cash value combines with your death benefit for a higher payout to beneficiaries. However, a modified endowment contract irreversibly restricts access to the account’s cash value until the policyholder is age 59.5. Withdrawing money before then will incur a 10% penalty.
History of the MEC
In 1988, Congress established the MEC rule because life insurance was a means to avoid capital gains taxes instead of its intended purpose of providing a death benefit for families. During the 1970s to mid-1980s, long-term capital gains taxes ranged from 20 percent to 39 percent. So, consumers could purchase life insurance policies that allowed hefty upfront payments or a single premium payment and defer taxes on the accumulated cash value.
In addition, they could take out tax-free loans from the policy, which could last a lifetime and be repaid from the eventual death benefit. However, the Technical and Miscellaneous Revenue Act of 1988 stopped this practice by introducing the “seven-pay” test, which identifies policies bought for investing and tax-sheltering instead of the death benefit and gradual growth.
What Is the Seven-Pay Test?
The seven-pay test is how the government determines if a life insurance policy turns into a MEC. Specifically, the test limits how much the policyholder can deposit annually during the first seven years. If the policyholder exceeds the limit with their contributions and doesn’t initiate a refund for the overage, the policy becomes a MEC.
For example, say you open a $250,000 life insurance policy. It has a $5,000 MEC deposit limit. So, you can deposit $5,000 per year for the first seven years of the policy. However, if you were to deposit over $5,000 during any of those seven years, the government would consider the policy a MEC and tax it accordingly.
This rule applies even if you try to make up for a year when your contributions for $5,000. For instance, funding the policy with $4,000 in year one and $6,000 in year two would put your policy into MEC status. Fortunately, if you overpay into your policy, your insurance company will notify you. Then, you can opt for a refund of the surplus payments to retain your policy’s status.
Lastly, it’s key to remember that policies that went into effect before June 20, 1988, aren’t subject to this law because it wasn’t in place yet. Plus, after the first seven years, the rule goes away for your policy unless you make a major adjustment, such as raising the death benefit.
Pros and Cons of MECs
As outlined above, MECs lose the cash value component of the death benefit. For instance, a $250,000 whole life policy that has accumulated $75,000 offers substantial cash reserves. However, if it becomes a MEC, you lose access to that money until age 59.5 unless you’re willing to pay a 10% withdrawal penalty.
In addition, your policy gains the same tax status as a non-qualified annuity, meaning you pay taxes on earnings. The final drawback is that MEC status is permanent once it occurs.
On the other hand, MECs still provide a death benefit to your beneficiaries. Plus, you’ll still experience the steady growth your life insurance policy originally offered and avoid the unpredictability of the stock market.
MEC vs. Life Insurance Contract
MECs differ from life insurance contracts because life insurance contracts don’t penalize withdrawals if the policyholder is younger than 59.5. Conversely, MECs impose the penalty. Plus, permanent life insurance policies have distinct tax-deferral advantages, while MECs have similar taxation as non-qualified annuities.
MEC Tax Consequences
Permanent life insurance policies shield earnings from taxes, meaning your money grows faster. Plus, you can take withdrawals or loans from your policy without incurring taxes if the amount is under the policy’s cost basis.
In addition, you don’t have to be a specific age to touch the money in your life insurance policy. Contrastingly, MECs lack these benefits. When you withdraw funds, your earnings come out first, meaning you pay income taxes on withdrawals. Plus, you must wait until age 59.5 to withdraw cash or pay a 10% penalty to do so beforehand.
Who Can Benefit from MECs
Although MECs experience a downgrade from a typical permanent life insurance policy, they still provide advantages. Specifically, if you want a tax-advantaged payout for your beneficiaries and aren’t bothered by overfunding your policy, a MEC can help. In addition, you won’t pay taxes on the money in your policy until you withdraw it. Therefore, high net-worth individuals might find MECs desirable.
The Bottom Line
A MEC is a life insurance policy that has received excessive deposits over the first seven years of its existence. Violating the seven-year rule produces an irrevocable change to the policy and it becomes a MEC. Your access to the policy’s cash is limited to age 59.5 and you might pay more taxes on the policy than originally planned. However, MECs still retain the primary function of life insurance: providing a hefty payout to beneficiaries upon the policyholder’s death.
Modified Endowment Contract Tips
Avoiding MEC status can help your life insurance policy function as intended. If you’re confused about how your insurance impacts your financial circumstances, a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Trying to keep a life insurance policy from becoming a MEC might seem like more trouble than it’s worth, but permanent life policies are cornerstones in countless Americans’ financial plans. Here’s how to tell if you need life insurance.
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Source: https://finance.yahoo.com/news/seven-pay-test-life-insurance-130037057.html